|Source: Capital Pixel|
As it happens, I am conversing with a potential client whose inherited IRA dropped 11% last year. His broker (not a registered investment advisor) invested the IRA in funds that have a front load of 5% and expense ratios averaging 1.22%.
I gave him a cursory overview of why that was horrendous performance and why he should be in low-cost index funds. He ran it past his broker who responded that he was in funds that had a superior 10-year record versus the S&P 500.
This brings us to a point of where there is a bit of odor in the room ,but we can't tell where it is coming from. Down 11% but in great funds! The potential client is a professional fireman and, unfortunately, not a professional odor spotter. A long-term track record would seem to be obviously important, especially when presented with multi-colored graphs on glossy paper. What isn't intuitive is that, if one has 30 funds ,it is rather easy to pick out the best 5 which probably outperformed the market. It is sort of like having 30 people flip a coin 10 times and finding the 4 or 5 that got the most "heads."
The question most people would not know to ask is "what does the evidence show on consistency of performance." And the evidence is clear - there is no consistency. The best coin flippers tend not to outperform in the next round, as is the case with active fund managers. In fact, the lack of consistency is also revealed as top investors fall to the bottom. In recent years, we've seen Miller, Paulson, Berkowitz, and even Bill Gross humbled by Mr. Market. Unfortunately, what people don't see are the investors whose retirement assets are put in jeopardy because they over invested with the "best and the brightest."
A related question arises as to the stock-picking ability of analysts. Sometimes I run into people who claim " Yeah but I've got a guy...". Here is an interesting piece written by Brett Arends, "Should you buy Wall Street's top stocks for 2012?", where he examined the top picks by analysts (paid the big bucks) out of the S&P 500. They were - 3.5% in 2011. The S&P 500 index was flat for the year and earned the dividend.
Imagine paying 5% up front and then 1.2% management fee to these analysts. Sure, some will come out on top but, over the long run, the odds decreased. You'd be better off putting your money with the top coin flippers in my opinion.
Disclosure: Investors should do their own research and consult a professional before making investment decisions. The information here is for educational purposes only.